Local Debts Defy Easy Solution

By

David Wessel

Updated Sept. 23, 2010 12:01 a.m. ET

Bankruptcy has become an acceptable and, in many cases, successful way for debt-burdened companies and consumers to get a fresh start. Airlines do it. Auto companies do it. Retailers do it. More than 1.6 million American households are expected to do it this year.

Buckling under crippling debts, state and local governments are unlikely to file for bankruptcy, but the alternatives could be worse, says WSJ's David Wessel.

But reneging on debts remains a rarity among U.S. state and municipal governments. Fewer than 250 of the nation's 89,000 local governmental units have filed for bankruptcy since 1980.

Recent close calls in Harrisburg, Pa., and Central Falls, R.I., spark predictions that the next phase of the financial crisis will be a tsunami of municipal bankruptcies and defaults. Muni-bond experts at rating agencies and bankruptcy lawyers assure us that isn't likely.

We've learned in the past few years to be skeptical of such assurances, but the experts probably are right on this one. Not because state and local finances are in good shape—they aren't—but because Chapter 9 of the bankruptcy code, the one that applies to local governments, is so unwieldy.

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And therein lies the big problem: If not bankruptcy, then what? There is no obvious mechanism for state and local governments to resolve the coming collision between competing claims of taxpayers, retirees (both current and future) and bondholders.

A bit of history: Amid collapsing municipal finances in the Depression—in Detroit, 36% of the taxes were delinquent in 1932 and 76% of tax revenue that arrived went to debt service—Congress allowed cities and towns, municipal utilities and the like (though not states) to go into bankruptcy.

Several Supreme Court decisions and congressional amendments later, the threshold for a municipal filing is much higher than for companies, judges' role more limited and the process largely untested. Bridgeport, Conn., was blocked from filing under Chapter 9 in 1991 because a federal court said it wasn't truly "insolvent," a test companies don't have to meet.

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Just Wednesday, an Alabama state judge, Albert Johnson, appointed a receiver for the troubled Jefferson County, Ala., sewer system, saying, "Bankruptcy is not a feasible alternative. Jefferson County, in order to progress, must have access to capital markets."

After Vallejo, Calif., won a federal judge's OK to use Chapter 9 in 2008 to extricate itself from union contracts, there were widespread predictions that other cities would follow.

"Two and a half years later that hasn't been the case," says Robert Kurtter, who oversees state and local government ratings at Moody's Investors Service. "What municipalities have discovered is that it is very expensive, the outcomes are uncertain because the rules are uncertain and it's not clear what the municipality gains."

Most municipal defaults and bankruptcies so far involve either behind-schedule, over-budget construction projects that didn't yield promised revenue or overstretched hospitals, not cities or counties.

The future, though, may not resemble the past. The magnitude of the problem is daunting. State and local governments have borrowed $2.4 trillion as of mid-2010, according to Federal Reserve data. That's up 35% from five years ago.

State and local governments—which employ more workers (19.5 million) than manufacturing and construction combined—have promised over $3 trillion in retirement benefits, more by some estimates. Their pension assets are at least $1 trillion shy of that, according to the Pew Center on the States.

"It doesn't seem like the current path is sustainable without a dramatic jump in economic growth," says Randal Picker, a University of Chicago bankruptcy-law scholar. And the odds of that are slim. Property and sales-tax revenues aren't likely to grow rapidly enough to solve the problem.

So what next? Stiff workers to pay bondholders? Cut benefits for new workers to protect generous retiree benefits? Break promises made long ago to now-retired employees? Fund workers' benefits by raising taxes on residents whose own employers have been cutting benefits?

An air of crisis is prompting a number of state and local governments to pare benefits for new, existing or retired workers, prompting lawsuits from, among others, retirees in Colorado, Minnesota and South Dakota. Rising voter anger could push more unions to surrender generous benefit deals struck in better times.

But the politics are treacherous, given public-employee unions' political power. And these one-at-a-time efforts may not suffice.

Optimists figure that state governments will rescue failing municipalities, essentially putting local governments into receiverships, if only because any municipal default increases borrowing costs for innocent-bystander municipalities in the same state. State government stepped in recently in Pennsylvania and Rhode Island. But some big state governments—California and Illinois in particular—are part of the problem.

So the talk inevitably turns to Washington, but the capital has bailout fatigue. It's hard to imagine Congress voting anytime soon to use taxpayer money to help states easily described as the most irresponsible. A more palatable solution may be an innovative public-pension authority that backstops state and local pension systems only if they agree to scale back benefits, an idea now floating around without much traction.

Bankruptcy is a last resort. To avoid it, state and local governments need an alternative that is less unappealing. They don't have one yet.

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